UK: Investment In Today’s Inflationary And Turbulent Times

The latest figures show UK inflation as measured by the CPI at
4.4% while interest rates languish at 0.5%. So how can you avoid
the erosion of cash deposits and maintain the real purchasing power
of invested capital? Before attempting to devise an investment
strategy to mitigate inflation, it's critical to take a step
back to understand its underlying causes. Bank of England governor,
Mervyn King, attributes the rise in the UK rate to three factors
over the past four years – a 'perfect storm' of
inflation shocks. There has been the rise in import prices
– 20% over the past four years – compounded by
a weak pound. Similarly, energy costs have soared while VAT has
pushed the CPI upwards.

Divided opinion

The Monetary Policy Committee has been divided into two camps.
The 'hawks' have claimed that the UK economy has lost
capacity permanently and that the output gap – the
difference between actual and potential GDP – is much
narrower than previously assumed. They say that if this is the
case, as the economy recovers, the rise in headline inflation will
translate into rising inflationary expectations (although as
economic growth has continued to disappoint, the number calling for
a rise in rates has fallen), hence their belief in the need for an
early increase in interest rates.

The 'doves', led by Mervyn King, have consistently
argued that the current spike in inflation is temporary and that
the UK economy is too fragile to absorb an increase in interest
rates with the economy still recovering from deep recession and
consumer debt levels so high. The labour market is in no position
to kickstart a wage cost spiral. Consequently, real disposable
incomes (i.e. after the effects of inflation) are likely to remain
under pressure. Also, with a very fragile housing market, now is
not the time to impose higher mortgage rates, they say. A tight
fiscal policy needs to be counterbalanced by a loose monetary
policy. So, according to the doves, the rise in CPI is temporary
and is forecast to subside next year.

The future direction of inflation will depend upon many factors
including exchange rates and indirect taxation, but it would seem
sensible to position portfolios for an environment in which nominal
GDP growth (i.e. real GDP growth plus inflation) is disappointingly
low, interest rates close to zero and inflation of 2%-3% per
annum.

Investors need to try to secure positive 'real' returns
(i.e. after inflation) while ensuring they have well diversified
portfolios invested across a broad spectrum of asset classes, such
as those outlined next.

Diversity is key

Equities – inflation could see equities benefit from
both rising prices and unit growth, but we would concentrate upon
well-capitalised, international companies with scope to increase
their dividends over the coming years. Dividends are likely to
become an increasingly important part of total return going
forward.

Inflation-linked bonds – even though real yields (i.e.
the return to maturity after inflation) have fallen, there is scope
for them to fall further. After all, in the 1950s to 1970s negative
real interest rates were the norm. Medium-dated UK indexlinked
government bonds (index-linked gilts) are only factoring in around
1.5% retail price index annual accrual rates going forward, which
may prove too low. (Source Bloomberg)

Gold and silver – traditional inflation hedges. The
1980 peak in gold in 'real' terms was US$2,251 which
compares with a current price of around US$1,800 (Source
Reuters).

Commercial real estate – over the long run, commercial
real estate has been a reasonable inflation hedge. However, because
rents are renewed at fixed periods, commercial property can incur
time-lag penalties while investors also carry the risk of periods
of vacancy and illiquidity.

Risk warning

Investment does involve risk. The value of investments and the
income from them can go down as well as up. The investor may not
receive back in total the original amount invested. Past
performance is not a guide to future performance. Rates of tax are
those prevailing at the time and are subject to change without
notice. Clients should always seek appropriate advice from their
financial adviser before committing funds for investment. When
investments are made in overseas securities, movements in exchange
rates may have an effect on the value of that investment. The
effect may be favourable or unfavourable.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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